Lessons from Bailout History II

On January 29, 2008, this Commentary covered lessons from previous bailouts worldwide. While I thought the topic was appropriate then, and focused on that topic in my Hudson Institute presentation of February 12, 2008, we have since seen the bailout of Bear Stearns and serious concerns about Lehman and – this week – the GSE’s, as well as the continuing bother of the classic too-big-to-fail doctrine. The supply of capital worldwide is faltering as sovereign wealth funds pulled back to the sidelines and policymakers are discussing allowing non-bank private equity funds to aid the recapitalization. IndyMac seems to be the next victim.

As a result of the continuing need for capital, press and policymakers are once again discussing direct government and government-sponsored bailouts. In doing so, however, I want to remind readers that there are (at least) three lessons that legislators and regulators – and investors – should be aware of before assembling any systemic bailout. Those lessons are knowledge accumulated through the history of successful and unsuccessful bailouts.

We probably won’t get it right the first time, but that would not be surprising, even in the global and historical context. The first binding principal is that if the target institutions like the terms, the bailout isn’t going to work. Second, adding leverage to insolvent institutions doesn’t help them achieve less insolvency. Third, recapitalizations work but only if properly structured.

1. Bagehot’s Dictum: Bail out Illiquidity, not Insolvency and Make Sure it Hurts

Despite the paucity of the FDIC’s problem bank list – and indeed because the FDIC is staffing up their resolutions division to historic levels – there are lot of banks in trouble today. The typical starting place for systemic assistance is Bagehot’s dictum. Bagehot’s dictum is the classic rule of bank policy (as opposed to monetary policy): lend to illiquid, but not insolvent, institutions at a penalty rate.

Bagehot therefore necessitates answering the question: which ones are insolvent and which just illiquid? Hence, the problem with applying Bagehot’s dictum to bailout policy is that it is difficult to distinguish illiquid from insolvent institutions during a financial crisis. Following the crisis, therefore, institutions that are clearly insolvent must be allowed to fail. Institutions at the margin may be candidates for targeted recapitalizations, but only in tightly supervised conditions. No institution should want a bailout – hence Bagehot’s stipulation of a penalty rate.

Even in the depths of the Great Depression thousands of banks were so deeply troubled that they could not be rescued. Those that received Federal recapitalization did so through preferred stock investment with full voting rights, which the Reconstruction Finance Corporation used to replace officers and directors and forcibly restore institutions to solvency. No bank wanted the funds and the Federal control that came with them. Today, while many banks are in trouble the FDIC does not seem to want to reveal the true extent of the difficulties. Those difficulties need to be revealed for Bagehot’s rule to be applied.

2. Loans Don’t Help

Because of the aversion to the harsh realities of Bagehot’s rule, nearly every bailout program begins by trying to lend money to the affected institutions in order to mask widespread insolvencies.

The Great Depression’s Reconstruction Finance Corporation attempted loans initially, but Mason (JFSR 2001), showed that loans to weak institutions actually increased the chance of failure. The Discount Window was opened to weak banks in the Thrift Crisis, but Schwartz (FRB St. Louis Review 1992), showed that discount window lending was a similar waste of money and effort. For Japan, Calomiris and Mason (NBER 2003) document the efforts to lend to banks in the early 1990s, and how authorities quickly concluded the effort was a failure and moved to recapitalizations.

In each case the effort was based on the allegation of the effectiveness of Great Depression programs administered by the Reconstruction Finance Corporation. The problem is, Mason (JFSR 2001) showed that those programs didn’t work. The short reason is that giving additional leverage to a bank already in trouble will only make the situation worse.

3. Recapitalizations Help, but Change Management and Close the Back Door

In each of those cases, recapitalizations were the next logical step. In the Great Depression, the Reconstruction Finance Corporation took a three-step approach: close the weakest banks, recapitalize the sounder institutions, and exert iron-fist control over the banking industry after the Federal Government owned voting stock in nearly every commercial bank (and many nonfinancial corporations) in the US. The Reconstruction Finance Corporation replaced officers and directors of banks and corporations and prohibited dividend payments for as long as they owned stock in the institution.

The Reconstruction Finance Corporation then used that same control to direct credit to strategic industries for the ensuing war effort and post-war recovery. Notably, the Reconstruction Finance Corporation was the only government agency to be shut down after its policies were alleged to part of widespread pattern of greed and corruption in the 1950s.

US officials wanted to reinstate the Reconstruction Finance Corporation recapitalization program in the 1980s Thrift Crisis, but found they did not have adequate authority to do so. Hence, regulators resorted to regulatory goodwill capitalization (forbearance) to fund bank capital, which was ultimately withdrawn by Congress. That withdrawal led to a Supreme Court breach of contract ruling against Congress and in decades of lawsuits (that are still being worked out). Congress’ withdrawal of regulatory goodwill was the only time Congress has been successfully sued.

Japan used direct recapitalization to rescue its banking system in the 1990s. Only Calomiris and Mason (NBER 2000) show that the Japanese forgot to restrict dividend payments as the Reconstruction Finance Corporation did in the 1930s US. As a result, much of the capital injected by the Japanese government was immediately tunneled out of the banks in the form of excess shareholder dividends. A second recapitalization program was necessary to make an impact.

Conclusions

Systemic bailouts are notoriously tricky. That is no reason, however, not to avoid the obvious pitfalls of such programs that have been repeated through history. The problem, of course, is that the industry won’t like bailouts that come at a cost – that is, bailouts that are effective. We are, therefore, most likely to repeat some significant policy mistakes. We can only hope, however, that those mistakes are not too costly.


Related RGE Content 

 

  1. Fed Grants GSEs Access to Discount Window, Treasury Asks for Unspecified Capital Injection Authority and An Increase in Credit Lines to GSEs
  2. The Costs and Benefits of the GSEs FannieMae and FreddieMac
  3. Lessons From Past Banking Crises: Are Good Banks/Bad Banks the Solution?

2 Responses to "Lessons from Bailout History II"

  1. John   July 17, 2008 at 1:45 pm

    Very good. I would love to also read your "Lessons from Bailout History I".Where can we find it? Can you publish it on this forum? Thanks

  2. Anonymous   September 30, 2008 at 9:06 am

    CONGRESSI have a solution,give every one from the age 21 to 90 a million dollars,except the rich and you won’t have any foreclosures and people will spend,but you will have to create jobs and work on alternative energy.This should be a lesson to our government not to let this happen again.